When India Killed Off Cash Overnight

Bhaskar Chakravorti, the dean of global business at The Fletcher School at Tufts University, analyzes the economic impact of India’s unprecedented demonetization move in 2016. With no advance warning, India pulled the two largest banknotes from circulation, notes that accounted for 86% of cash transactions in a country where most payments happen in cash. Chakravorti discusses the impact on consumers, businesses, and digital payment providers, and whether Indian policymakers reached their anti-corruption goals. He’s the author of the article “One Year After India Killed Off Cash, Here’s What Other Countries Should Learn From It.”

CURT NICKISCH: Welcome to the HBR IdeaCast from Harvard Business Review. I’m Curt Nickisch, in for Sarah Green Carmichael. On November 8, 2016, India’s prime minister, Narendra Modi, announced a new policy that sent shockwaves through his country’s economy.

NARENDRA MODI: Brothers and sisters, to break the grip of corruption and black money, we have decided that the 500-rupee and 1,000-rupee currency notes presently in use will no longer be legal tender from midnight tonight.

CURT NICKISCH: Overnight, most of the country’s paper money was simply no longer money anymore. This policy is called demonetization. And in a country where most transactions still happen with cash, it was a drastic measure, to say the least. Why do it? Modi said India had to. He said tax evaders and criminals were piling away loads of cash.

NARENDRA MODI: The 500 and 1,000-rupee notes hoarded by antinational and antisocial elements will become just worthless pieces of paper.

CURT NICKISCH: Did criminals end up getting stuck with those worthless pieces of paper? Was everyone else left with a stronger economy? Here to break down what happened is Bhaskar Chakravorti. He’s an economist and the dean of global business at the Fletcher School at Tuft’s University. And he’s the author of the HBR.org article “One Year After India Killed Off Cash Here’s What Other Countries Should Learn from It.” Bhaskar, thanks so much for talking with the HBR IdeaCast.

BHASKAR CHAKRAVORTI: Thank you for having me, Curt. It’s a pleasure to be here.

CURT NICKISCH: So this sounds really drastic, this kind of move to take currency out of circulation and put new bills in so suddenly. And I just wonder what that must have been like?

BHASKAR CHAKRAVORTI: Well, one way to imagine what that must have been like is, open your wallet and see what you have inside it.

CURT NICKISCH: Well, hang on. I’ve got my wallet right here. So I’ve got it. I’ve opened it up. You don’t want to know all the cards I have.

BHASKAR CHAKRAVORTI: What do you have in cash?

CURT NICKISCH: It’s funny. I have two $20 bills that are probably leftover from an ATM visit weeks ago. Most of the time, when I’m paying for lunch or whatever, I’m using the credit cards that are in here. So I have to admit, I have $40 in here, two $20 bills, but they’ve been in there for a while.

BHASKAR CHAKRAVORTI: Yeah, well, that’s good to know, because if I were to take your wallet, and basically take everything in that wallet and just give you back your driver’s license, that is roughly speaking what a typical Indian consumer probably felt like after midnight of November 8, 2016. The move that the Indian government made to demonetize the two largest denomination banknotes, which were roughly the equivalent of $15 and $7.50, the 1,000-rupee and the 500-rupee note, constitute about 86% of all currency in circulation. Also, it’s a society that is about 90% cash dependent. So I’ve pretty much taken 90% of your credit cards as well, if not more. So essentially you have very little to work with to make payments.

CURT NICKISCH: OK, and just to make this perfectly analogous, this would be as if I only had $40 in my wallet and no credit cards. And you took the money away, because that’s more like what it would be like for an Indian consumer.

BHASKAR CHAKRAVORTI: Yeah, and then let me kind of make it a little bit more nerve-wracking, which is, 90% of the Indian workforce is in the informal sector. What that means is that they get paid in cash. So not only do you have very little in your wallet to pay people with, you also have very little by way of getting paid, whether that work is as a day laborer or as a shopkeeper or as somebody who is providing some kind of service like delivering something to your home.

CURT NICKISCH: So, practically, the way of paying for commercial interactions disappears overnight. And so if you want to be able to pay somebody or get paid, all this has to be sorted out first. And that’s why there were long, long lines at banks, where people went in with these bills and tried to trade them in for the new 1,000-rupee notes and 500-rupee notes.

BHASKAR CHAKRAVORTI: That’s right. They had new 1,000 and 500-rupee notes, and they also had a new 2,000-rupee banknote that they had issued. And part of the challenge was that there wasn’t enough of this new currency in circulation when people were lining up. So the lines were long to just deposit their old banknotes, and the other challenge was that the 2,000-rupee banknote comes in a different size. So as a result, the ATMs were not calibrated to deal with this new dimension of the currency.

CURT NICKISCH: Yeah, those had to be re-engineered as well. Yeah. Which probably doesn’t happen well if you’re trying to do that in a hurry, without a lot of warning.

BHASKAR CHAKRAVORTI: That’s right.

CURT NICKISCH: So let’s explain why there was so little warning. What was the reasoning for saying to the entire nation, you have, in two hours, those bills in your wallet are worthless?

BHASKAR CHAKRAVORTI: So the ostensible reason was for the government to take a bold move to root out corruption. And there is this notion called black money in Indian, called black money because this is money that people do not declare to the tax authorities. And this is money that you might have earned in a transaction that you don’t want to report to the tax authorities. So the idea was to try and root out these kinds of activities and expose it. And if you did own such black money, and when you present it to a bank teller, in the process of depositing your old banknotes, somebody would ask you where you got it from. So that was the notion, that we would root out corruption. And in order to make sure that this operation was a success, you had to make sure that it was done without any advance warning so people would not have a chance to rush to the bank and essentially launder their money in advance of the announcement.

CURT NICKISCH: And that meant that farmers left their fields because they knew that they only had so many days to be able to change this money out. And so some people lost crops. Some businesses went out of business. Some people didn’t get work, because they had to wait until bills got swapped out to be able to be paid. So the cost of making that move, at least from an economic perspective, and you are an economist, must have been really high.

BHASKAR CHAKRAVORTI: Yeah, absolutely. There were pretty significant costs. There were a number of people who died in the process of standing in line and waiting for the bank teller. There were people who were ill, and they could not be seen in hospitals or be taken to an emergency care situation because people didn’t have money to pay for some of these services. And then, of course, the economic costs. The economic costs initially did not show up in the statistics. So when cash gets taken out of circulation, it causes a drop in this information transactions, and much of that informal economy gets cut back. And that initially didn’t get captured in the GDP statistics. But eventually the statisticians caught up, and basically what we saw was, before this period of demonetization and what came after it, before that period, India was the fastest growing large economy in the world. In purchasing power parity, it was the third largest economy in the world. After the demonetization peri5od, and after a proper accounting of what had happened to the GDP, the growth rate of GDP went from somewhere around 7.5% to 5, anywhere between 5 to 6%. So a significant drop.

CURT NICKISCH: Yeah, still a growth rate that other countries would die for.

BHASKAR CHAKRAVORTI: Oh, absolutely.

CURT NICKISCH: But for a developing economy, could be seen as sluggish.

BHASKAR CHAKRAVORTI: Yes.

CURT NICKISCH: So let’s talk about the positive sides, because the government that instituted this, really with a goal of reducing corruption, and getting more people to open bank accounts, which some people had to do, getting more people to make their transactions other ways besides using cash, so that more of this could be taxable and reportable, those were some of the stated goals for doing this. And how did that turn out?

BHASKAR CHAKRAVORTI: If you were to look at what happened to tax revenues and tax collection, certainly there was a positive impact on that. The tax base in India has gone up since demonetization. The volume of transactions that typically used to involve a significant amount of cash and black money in the transaction, some of that went down, in particular, property transactions. So it definitely has had a positive impact on the tax base. Granted, the tax base was ridiculously low in India. Only 2% of people actually pay taxes. Only about, yeah, so it’s a really small, it’s a big problem to take on.

CURT NICKISCH: Right. But what about the illegal assets that were also a target of this policy move?

BHASKAR CHAKRAVORTI: It turns out that only about 6% of all illegal holdings are in cash. So which means the demonetization hammer was put against a relatively small nail. There’s 94% of other kinds of assets that were completely unaffected by this draconian move. Now granted, people are going to think twice about engaging in illegal activity, regardless of how the assets are held. However, this was an approach that would have had a limited impact anyway. And I think the other comment is that 99% of the money that was in circulation in the form of 1,000-rupee and 500-rupee banknotes, they were all returned to the banks. In other words, the government was expecting that about 15-20% of the currency would not be returned, and that would help kind of expose the degree of illegality. But it turned out that money was laundered quite successfully.

CURT NICKISCH: Just to spell that out, that people who had too many of these bills had a lot of illegal assets that you just wouldn’t be able to swap it out. But you’re saying that didn’t happen.

BHASKAR CHAKRAVORTI: That didn’t happen, yeah.

CURT NICKISCH: And why not?

BHASKAR CHAKRAVORTI: Well, because people figured out ways to bring it back to the bank without having to give a lengthy explanation for how they had collected that much money.

CURT NICKISCH: They certainly had an incentive to do so.

BHASKAR CHAKRAVORTI: Yeah, they had an incentive to do so, and then as with every society, whenever you put constraints on it, people find creative ways of getting around constraints. So there was essentially a little cottage industry that developed to help you launder your money.

CURT NICKISCH: Like what kind of cottage industry?

BHASKAR CHAKRAVORTI: So for instance, if you have 1,000-rupees, you could split it up into smaller chunks and deposit it into, in smaller accounts which would go under the radar, and questions would not be asked. And in exchange for creating those smaller accounts, a small fee was charged by whoever was opening an account in your behalf.

CURT NICKISCH: Another stated goal, or another stated motivation, at least, was to move India away from the pole of being a completely cashless society, to get people to try out digital payments. And there were some digital payment providers, PayTM was the biggest one that really did well by seizing on this moment. They saw huge growth rates, and a lot of people did try out digital payments and other forms of payments besides cash for the first time. And what were the effects there? Because all of these problems did create an incentive to try something like that, where people just wouldn’t have made the effort before.

BHASKAR CHAKRAVORTI: Yeah, so India, as you observed, was 90% cash dependent when this whole process of demonetization was launched. And mobile wallet companies like PayTM, Mobiquick, their usage spiked, and they saw an enormous growth in both the number of accounts and the volume of transactions that were processed by them. So there was a fair amount of creativity and usage of digital payments that picked up right after demonetization.

CURT NICKISCH: Yeah, what is the payment system like now, over a year out?

BHASKAR CHAKRAVORTI: So over a year out, what we found, indeed there was a spike, and as with all spikes, on one side of the spike there is a rapid rise. On the other side of the spike is a rapid drop. So people, as soon as new currency came back into circulation, people went back to using cash, and for a number of reasons. People like to use cash. And ATM withdrawals in April of 2017 were roughly speaking at the same levels as ATM withdrawals in April of 2016.

CURT NICKISCH: And what about bank accounts?

BHASKAR CHAKRAVORTI: So the number of bank accounts in India have definitely gone up. And this is something that preceded demonetization. India at one point held the Guinness Book of World Record in terms of the number of new bank accounts that have been opened in a given period of time. And this was part of a larger set of initiatives to get a greater financial inclusion in the society. Debit card usage went up quite significantly since demonetization. So there has been some progress in terms of both financial maturity and financial sophistication, but not anywhere near the degree and the extent that you would want, and certainly not anything that would justify a move as draconian as what was executed in November 2016.

CURT NICKISCH: So let’s talk about something that is a little confounding, perhaps, to you and maybe to many listeners, because they would hear about this, and they would hear about draconian measures, as you’ve described these. But a big shock with little benefits that you’ve described here. Not exactly the sort of benefits that you think would be commensurate with that kind of big, bold policy move. On the other hand, the Prime Minister did very well, and his party did really well in regional elections afterwards. His popularity rating has gone up. Did that surprise you, just the fact that so many people in Indian society, despite the hardships that it cost many, have supported the move, or haven’t really punished the government that made this policy move.

BHASKAR CHAKRAVORTI: So indeed at first blush, this does seem like a giant paradox. Right? Because the Indian consumer, and particularly the middle class and the poorer people, were the ones who were most affected by demonetization. And they happened to be one of the strongest supporters of the move. Which seems really odd. Now, if you were to step back and look at the larger picture, and this doesn’t have to do with India, you can see that playing out everywhere, most recently in Malaysia. We’ve seen that play out in Europe. We’ve seen that play out right here in the United States. Which is that when somebody comes in and says, I will drain the swamp, I will root out corruption, that is a very powerful political message. And even if that requires a certain amount of sacrifice on a citizen’s part, they feel that somebody is standing up for me. Somebody’s standing up for the little guy.

CURT NICKISCH: It didn’t surprise you.

BHASKAR CHAKRAVORTI: Well, of course, it surprised me, because it seemed irrational. But when you step back and reflect on why, then it didn’t surprise me.

CURT NICKISCH: And this isn’t necessarily new with, I mean, this has always been the case that what politicians want to do very often differ from what the best economists in any country would say should happen with the tax system, with trade tariffs, you know, go on down the line. They’re not the ones making policy. It’s politicians making policy, and so this isn’t necessarily a new thing recently, but it’s a renewed annoyance for an economist from India, I suppose.

BHASKAR CHAKRAVORTI: Well, I guess it would be not necessarily an annoyance, but perhaps a vexing issue, not just for economists, but for political scientists as well, because you would imagine that voters are eventually they act out of self-interest.

CURT NICKISCH: Now, India is a unique country and society. It is a complex one. But there are lessons here, probably, for other countries. Like, what would you tell people in other places that are more, especially countries that are more cash dependent, or countries where they’re trying to transition towards digital payments. What recommendations do you have for those places?

BHASKAR CHAKRAVORTI: Well, I guess the first recommendation I would have is that countries like India and countries around the world where cash is prevalent, we should be using less cash, for a number of reasons. And some of the most significant reasons being that cash does impose a cost on society. And it imposes costs on consumers. It imposes costs on businesses. And most significantly, it imposes costs on government. And those costs have to do not just with printing cash and transporting cash and keeping cash in banks and vaults and so on. It’s also the fact that a cash-based economy goes under the radar, and there is essentially a tax gap that is created by the presence of cash in society. And a tax gap means lower revenues that the government can use for public services. So there are a number of reasons why we should be utilizing the variety of different alternatives, digital, electronic, credit cards, whatever the alternatives are, which help you keep a paper trail of payment transactions that are happening in the economy.

CURT NICKISCH: So the first is, you know, recognize that one of the motives behind this move to move towards more digital payments was a very good one.

BHASKAR CHAKRAVORTI: Absolutely. So the second lesson is that as we transition from cash to digital payments, we have to understand the context in which people make payments. And that context has to do with the infrastructure context. If people have to make payments on their phones, there has to be a reliable digital infrastructure. So I feel that the payment is secure, that it will actually go through. My phone is sophisticated enough to manage that. People in many cases have to have bank accounts tied to their payments. So you need the financial infrastructure to be in place as well. You also need a certain degree of education and financial sophistication for people to feel comfortable in dealing with a virtual transaction. Because the whole thing about cash is, it’s physical. I can feel it. I can see it. And I know that I have received the money or have given the money. But when something is virtual, it does require a degree of trust in this invisible system that is working behind the scenes. And we have to be respectful of that, whenever we plan for a transition from physical to virtual.

CURT NICKISCH: Bhaskar, thank you for taking through this whole thing with us.

BHASKAR CHAKRAVORTI: Great, thanks for having me, Curt. I enjoyed it.

CURT NICKISCH: That’s Bhaskar Chakravorti. He’s the dean of global business at the Fletcher School at Tuft’s University, and he’s the author of the article “One Year After India Killed Off Cash Here’s What Other Countries Should Learn from It.” You can read it at HBR.org. This episode was produced by Ramsey Khabbaz. Adam Buchholz is our audio product manager, and we get technical and production help from Rob Eckhart. Thanks for listening to the HBR IdeaCast. I’m Curt Nickisch.